DP6501 Monetary Policy, Default Risk and the Exchange Rate

Author(s): Bernardo Guimarães, Carlos Eduardo Soares Gonçalves
Publication Date: September 2007
Keyword(s): default, exchange rate, identification through heteroskedasticity, monetary policy
JEL(s): E5, F3
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6501

In a country with high probability of default, higher interest rates may render the currency less attractive if sovereign default is costly. This paper develops that intuition in a simple model and estimates the effect of changes in interest rates on the exchange rate in Brazil using data from the dates surrounding the monetary policy committee meetings and the methodology of identification through heteroskedasticity. Indeed, we find that unexpected increases in interest rates tend to lead the Brazilian currency to depreciate. It follows that granting more independence to a central bank that focus solely on inflation is not always a free-lunch.